The payback period (PBP) is the time it takes to recover the initial investment. Likewise, Salvage value is the amount we can obtain after selling an asset. These two concepts are interrelated with one another. The only reason to consider salvage value to calculate the payback period is it reduces the time to recover the initial investment.
In our example of a dairy company, we purchased a cheese processing machine for eight years at $20,000, and in eight years, we can resale it at $ 8,000. The annual cash flow generated by the company is $ 2,000. Its payback period is ten years.
But by using salvage value,
Annual Cash inflow = {Annual Cash Flow + (Salvage Value / Useful Life)}
Annual Cash inflow = {2000+(8000/8)} = $ 3,000
New Payback Period with Salvage Value = $20,000/ $3,000 = 6.67 years.
The payback period is shorter by 3.34 years, and it’s because of the salvage value.
